Post-war Uncertainty Lingers

Aug. 5, 2003
A Financial Update
The war with Iraq has wound down, but uncertainty over the outlook for the economy remains. "The pace of economic activity continued to be lackluster during March and the first two weeks of April," the Federal Reserve Board said in its April Beige Book survey. The Conference Board's index of leading economic indicators slipped 0.2 percent in March, a slight improvement from the revised 0.5-percent decline in February. Joblessness, layoffs, and sluggish business and consumer spending have acted as drags on the economy.
Consumer sentiment, based on the University of Michigan index, increased in mid-April from mid-March as the war's outcome became clear, but whether this signals a rebound in consumer spending is uncertain - after the Gulf War, consumer spending increased but then subsided.
On a positive note, interest rates are expected to remain stable or increase only slightly this year, absent a surge in inflation. Corporate earnings may have started to recover - most companies have been meeting or exceeding first-quarter earnings estimates. Oil prices appear to be falling back from recent peaks. U.S. retail sales rose by 2.1 percent in March from February - the largest gain in more than a year. (Retail sales fell 1.3 percent in February, a decline attributed mainly to war concerns and bad weather.) Whether Congress and the Bush Administration can agree on tax cuts that give a fast boost to the economy remains to be seen.
At present, corporate utilization of equipment is quite low, with capacity at a little more than 75 percent, but some equipment is obsolete. Furthermore, business spending has fallen so sharply in the past two years that it has not kept pace with the rate of equipment obsolescence. An April survey by Manufacturers' Alliance/MAPI, a nonprofit research group, found that 47 percent of major manufacturers expect capital spending to be higher this year than last year, up sharply from 12 percent a year ago. With the war over, businesses may see less risk in the geopolitical outlook, and may be more willing to invest. Their needs for new equipment eventually should trigger a sustained revival in capital spending growth.
A surge in defense spending is not expected to give the same boost to the economy as in past wars. Government spending for defense and homeland security, including the war in Iraq, is forecast to increase by about $98 billion this year over last. Because of a dearth of business from the private sector, businesses have not had to add jobs and increase capacity to accommodate defense-related work. More defense spending has mainly helped only a few areas of the United States, including Southern California. Northrop Grumman Corp.'s first-quarter profit rose partly because of increased defense spending. The company raised its earnings forecast for the year.
At the state level, the budget crises in California and other states have triggered spending cuts and layoffs of public workers, with ripple effects through the economy: higher unemployment, reduced consumer spending, and less public spending, including spending that helps to stimulate the private sector. The recovery of the national economy depends in part on states making progress in resolving their budget problems.
In the housing sector, low interest rates and rising home prices have sustained a boom in refinancings and home sales. The increase in housing wealth from rising prices has partly offset the loss of equity wealth from lower stock prices, but not enough to prevent a decline in household wealth (housing and equity wealth) over the past three years.
Housing prices have increased faster than personal incomes in recent years. In order to buy homes, many consumers have reduced down payments and increased mortgage payments. If rates rise, and variable rate mortgages are adjusted upward, some highly leveraged owners could be squeezed by higher mortgage payments.
In an article in the June 2002 issue of Buildings magazine, the Lusk Center for Real Estate, University of Southern California in Los Angeles, forecasted that Real GDP would grow 2 percent to 2.5 percent in 2002, compared with 1.7 percent growth in 2001. Real GDP increased 2.8 percent in 2002, helped by a surge in consumer and government spending in the third and fourth quarters. Consumer spending has been a mainstay of the economy. It accounted for four-fifths of economic growth for much of last year instead of the usual two-thirds.
GDP growth has remained relatively weak in the first part of 2003. The Commerce Department reported annualized first-quarter GDP growth was 1.6 percent compared to 1.5 percent in fourth-quarter 2002. There will have to be a significant surge in economic activity to meet the consensus forecast that annualized GDP growth in the fourth quarter of 2003 will increase to 3 percent to 3.5 percent. Stronger economic growth is needed to create jobs and stop the hemorrhaging in the job market. Non-farm job losses have totaled about 2.4 million over the past two years, the weakest year-to-year job market performance since the Eisenhower years. Coincident with this, personal income growth of 2.8 percent in 2002 was the lowest rate of growth in 30 years.
A recovery of employment growth would be a boon to the nation's beleaguered office markets. Demand for office space has shrunk and vacancy rates have increased because of corporate downsizings and layoffs over the past two years. Furthermore, companies have a better understanding of their space needs compared with a few years ago, and they are learning to make more efficient use of their space.
Because of "decision paralysis," companies are extremely cautious about leasing new space and extending existing leases. In one Los Angeles office building, leases on a million square feet expired in December, and 80 percent of this space was extended on a month-to-month basis. On the supply side, while new office construction has dropped, some markets are still working off an excess of space from the boom. Even when the economy starts to recover, the recovery in office markets will lag until this surplus space is burned off and vacancy rates start to drop. The USC Lusk Center Casden Real Estate Economics Forecast indicates the Los Angeles region's office and industrial markets will start to show signs of recovery in mid-2003 as the regional economy begins to rebound, and a full recovery will follow in 2004.
In the first quarter of this year, the national office vacancy rate increased to 16.9 percent from 16.5 percent in the final quarter of 2002, according to CB Richard Ellis' Torto Wheaton Research. However, some markets have bucked the trend by reducing vacancies over the past year. Orange County's vacancy rate eased to 17 percent in the first quarter from 17.9 percent in the 2002 first quarter; while Riverside's vacancy dropped to 10.2 percent from 15.1 percent over the same period. By contrast, San Francisco's office vacancy rate reached a new high in the first quarter of this year, topping out at more than 20 percent. Like the office sector, the industrial, retail, and multi-family sectors are also feeling the effects of a slow-growth economy. As with the office sector, the performance of these other sectors varies from market to market.
Despite the soft office rental market, office properties continue to attract investment. Compared with other asset classes, commercial real estate offers relatively stable cash flows and competitive returns, and the opportunity to acquire assets at the bottom of the market and ride the recovery. Financing costs are at record lows, and leveraged yields are attractive.
The leverage of public REITs currently is about 40 percent. By comparison, in the recession of the early 1990s, owners often were leveraged at 70 percent or more, and high vacancies drove some into bankruptcy. But investment in commercial real estate is not without risks. Asset prices are very high relative to income, and high vacancy rates and diminished property cash flows have made investors cautious. They are concentrating on investments in office properties that have credit-worthy corporate tenants and are located in selected markets such as Los Angeles, New York City, Chicago, and Washington, D.C. Lesser-quality properties are seen as more of a risk because some tenants have weak credit ratings and diminished growth prospects. In fact, for most property types, there seems to be a widening of the spread between cap rates for high-risk and low-risk properties. Investors are willing to pay more for properties with solid tenants and relatively certain cash flows.
At present, corporations are primarily focused on defensive strategies: consolidating space, squeezing maximum efficiencies out of space, and leasing space on terms that provide for fast exits. But as the economy recovers and companies start growing again, they will need to start thinking of their future space needs and how to lock up space at attractive rental space. Likewise, investors will need to look at their investment strategies. They will have decisions to make about which assets to hold as long-term investments, and which to sell to realize capital gains and raise capital for new investments. The costs of acquiring or refinancing commercial properties will increase as interest rates rise, and at some point, some investors may decide to reduce their real estate exposure and look for alternative investments.David Dale-Johnson is associate professor of Finance and Business Economics, Marshall School of Business and Lusk Center for Real Estate, University of Southern California in Los Angeles.

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